Some business expenses run like clockwork. You know exactly when your facility’s rent payment will be due and how much you’ll need to pay. Other future expenses, while unavoidable, involve some level of uncertainty. For example, you can estimate the percentage of customers that are unlikely to pay their bills this year, but you don’t know exactly how much money will be uncollectible. For these expenses, businesses can use what’s called a provision — money set aside to cover specific future financial impacts such as bad debt, taxes and inventory write-downs. Provisions help paint a more accurate picture of a company’s financial situation.
What Are Provisions in Accounting?
Provisions are funds set aside by a business to cover specific anticipated future expenses or other financial impacts. An example of a provision is the estimated loss in value of inventory due to obsolescence.
- Provisions vs. reserves. Provisions and reserves both represent funds set aside for future expenses. However, there are important differences between them. Provisions are estimated amounts allotted for specific expenses. In contrast, reserves are funds allocated from profits to strengthen a business’s financial standing and provide the flexibility to address any unknown liabilities and losses.
- Provisions vs. accrued expenses. A key difference between provisions and accrued expenses is the level of certainty. Provisions are for probable future expenses where there’s uncertainty about when they will be paid or how much will actually be spent. In contrast, an accrued expense is one that the company knows with certainty. The company knows how much will be due and when — but it hasn’t yet made payment. Accrued expenses include items bought on credit. A restaurant, for example, may get food and beverages delivered daily but receive a single bill at the end of each month. Other common forms of accrued expenses include salaries and loan interest payments.
- Provisions are funds set aside for specific probable future expenses or other financial impacts such as losses in value.
- Financial obligations are categorized as provisions when they are likely to affect the company’s finances, but there is uncertainty about their value or timing.
- Examples of expenses that provisions may target include bad debt, warranty-related costs, reductions in asset or inventory value and income tax liabilities.
Provisions in Accounting Explained
Companies sometimes know they are likely to face unavoidable future costs, even though they may not know exactly how large those costs will be or when they’ll need to be paid. Provisions help companies plan for these expenses by allocating money in advance. Companies often estimate the amount to set aside by examining historical data. For example, a company may be able to estimate how much to allocate for bad debt based on past averages. Provisions are marked as current liabilities on the company’s balance sheet and are included within the appropriate expense category on the company’s income statement.
Why Are Provisions Important?
Provisions enable companies to gain a more accurate assessment of their financial position. This helps them shape better business decisions and provide shareholders with a clear picture of their finances. For example, a company that warranties its products knows, based on historical data, that it is likely to face repair or replacement costs for a percentage of the products sold in a specific period. By including a provision for those costs during the same period as the products are sold, the company can more accurately match its expenses and revenue for the period, thus presenting a clearer view of profitability.
How Do Provisions in Accounting Work?
An essential step in creating a provision is to estimate the amount of funds to set aside. It must be a reasonable estimate. Companies will often review their past experiences, recent financial statements or industry averages to establish the estimated size of the provision. For example, a company may estimate the amount of revenue that will be uncollectible based on historical bad debt. The provision is then recorded as a liability on contra-asset on the company’s balance sheet and as an expense on the income statement.
International Financial Reporting Standards (IFRS): IAS 37 Provisions, Contingent Liabilities and Contingent Assets
For companies that need to comply with International Financial Reporting Standards, such as publicly traded companies based outside the U.S., the criteria for defining provisions and other potential expenses are laid out in International Accounting Standard 37: Provisions, Contingent Liabilities and Contingent Assets.
- Provisions are defined in IAS 37 as liabilities of uncertain amounts or time frame. A company should recognize a provision if it’s more than 50% likely that an obligation will require payment or will impact other economic resources. IAS 37 breaks up such obligations into two types: legal and constructive. Legal obligations include those required by legislation or contracts. A constructive obligation results when the company’s previous actions or statements have created an expectation that it will accept certain responsibilities — for example, if it typically bears the cost of cleaning up any environmental damage even when there’s no legal liability to do so.
- Contingent liabilities. A key difference between a contingent liability and a provision is the level of probability. In IAS 37, a contingent liability is a potential financial obligation that is beyond the company’s control but is less than 50% likely to have a financial impact, or its amount cannot be reliably estimated.
- Contingent assets are potential assets that may or may not materialize, depending on events beyond the company’s control. For example, a company may believe it is possible it will receive a payment from a current legal action but is not sure whether it will win the case, how much it will receive or when.
Types of Provisions in Accounting
Companies can establish different types of provisions to cover many potential expenses or other situations. Examples include:
- Bad debt: Bad debt is one of most common types of provision. A bad debt provision is an estimate of the amount of accounts receivable that will not be collected. Businesses typically estimate this amount based on previous accounting periods or industry averages.
- Guarantees: A guarantee occurs when one business takes responsibility for another business’s financial debts if that business can’t settle its liabilities. A company may make such a guarantee if it has a vested interest in the success of the other business.
- Loan losses: Banks and other lenders may establish loan loss provisions to account for uncollected loan principal and payments. Loan loss provisions can be used to cover bankruptcies, loan defaults and renegotiated loans that result in receiving lower payments than originally estimated.
- Tax payments: A tax provision is the money set aside to pay the company’s estimated income taxes.
- Pensions: Companies that offer pensions may have a responsibility for future retiree expenses. Many companies establish pension provisions to address these future obligations.
- Warranties: Many companies offer a warranty on their products. They need to set aside dollars for repairs and replacements, based on the estimated percentage of products that will require warranty service.
- Obsolete inventory: Provisions can help companies plan for the loss of revenue due to inventory that goes unsold or becomes obsolete and must be marked down.
- Severance payments: Companies use severance provisions to account for severance payments to employees that leave the company due to layoffs or other reasons.
- Restructuring: Company restructuring can improve a company’s profitability in the long term but may involve sizable costs in the short term. Restructuring provisions set out the probable direct costs of reorganization, such as facility closure expenses, employee termination costs and consulting fees.
- Depreciation: Depreciation is a method of accounting for an asset’s decline in value over time. A depreciation provision represents the depreciation during the current accounting period.
- Asset impairments: Asset impairments happen when the current market value of an asset drops below the carrying value recorded on the company’s balance sheet. Recording the impairment as a provision prevents overstatement of the asset’s value.
How to Recognize Provisions in Accounting
Specific criteria must be met for a company to recognize a provision, according to the IFRS IAS 37 standard. Among them:
- The company must have a current obligation arising from a past event.
- Settling the obligation is expected to result in an outflow of funds or other economic impact, such as a loss in value.
- The company can reliably estimate the amount of this obligation.
If there’s a question about recognizing a provision, a business should consider whether there’s a way for it to take future actions to avoid the financial obligation. If the answer is yes, the provision may not be needed. If not, then a provision is necessary.
Requirements for Creating Provisions
Not every potential future expense will qualify as a provision. Here are some of the considerations for determining whether a potential financial obligation should be treated as a provision.
The obligation likely will decrease the company’s economic resources or financial position.
The definition of “likely” depends on the accounting guidelines in effect. Under IFRS international accounting standards, an obligation should be recorded as a provision if it’s more than 50% likely to result in an outflow of cash or other economic resources. Under U.S. Generally Accepted Accounting Principles (GAAP) guidelines, the threshold is often closer to 75%. One example that typically meets both of these thresholds is provisions for income taxes, since it’s very likely that companies will actually have to pay income taxes on their profits.
The obligation must stem from an event that results in a legal or constructive liability, and it should reflect the period during which the company is liable. In some cases, companies may need to make provisions for financial impacts that can occur over several years. Let’s say a car manufacturer provides a warranty covering the car’s first three years or 36,000 miles, and there’s a product malfunction at 22,500 miles in year two. Because the company has a legal obligation to cover the expenses, it creates a provision based on the estimated percentage of vehicles that will need warranty repairs and the average cost.
Companies need to comply with regulatory requirements applicable to their region and industry, including taxation and legal requirements, as well as accounting guidelines.
How to Record Provisions
Estimating and recording provisions is a multistep process. Here’s how to do it:
- Quantify the amount of funds you need to set aside. This must be a reasonable estimate. Companies will often look to past experiences, recent financial statements or industry averages to establish the estimated amount.
- Record the estimated amount for the current period as an expense. This will appear on the company’s income statement.
- This amount is also added to the opening balance of the corresponding liability or contra-asset account. This will be reflected on the company’s balance sheet.
- The amounts should be monitored over time and adjusted to reflect reality. For example, a company may create a provision for bad debt. If it gives up trying to collect what’s owed on a specific account, it reduces the amount of the bad debt provision as well as the total value of accounts receivable.
Examples of Provisions in Accounting
Provisions can be used by many types of organization for a diverse set of potential situations. Here are some examples:
- A furniture company sells 20 dining room sets for a total of $50,000 in a month. Since historical data points to an average 4% bad debt rate, the company can reasonably expect to fail to collect $2,000 of the month’s revenue, so it creates a bad debt provision for that amount.
- An electronics manufacturing company offers a one-year warranty on every television it sells. The warranty specifies the conditions under which the manufacturer agrees to compensate the consumer for a defective product. The company sold 1,000 televisions at an average price of $750 last year. Based on prior experience, the company expects 6% of the televisions to be defective, with an average repair cost of $80 per unit. That adds up to 60 defective TVs and an estimated total warranty repair cost of $4,800 for the year, so the company creates a provision for that amount.
- A youth sports organization knows that many of the goalposts on its football fields need repairs, so it designates money at the start of the calendar year to replace them over the summer. The size of the provision is contingent on a preliminary estimate obtained from a contractor.
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Provisions enable companies to reflect the likely impact of future expenses or losses in situations where there is some uncertainty about the amount of the expense or its timing. Provisions may represent funds put aside for many different purposes, such as bad debt, income taxes, warranty repairs and inventory write-offs.
Why are provisions created?
Provisions enable companies to set aside funds for future expected expenses when there’s a degree of uncertainty about the amount or timing of the expense. They help provide a clearer picture of a company’s finances, so companies can make better-informed decisions about future spending and business plans.
What are tax provisions?
A tax provision is the money set aside by a business to pay its income taxes for the current period. The size of the provision is based on a company’s estimate of its profit after any applicable tax deductions it claims.
What are common types of loan provisions?
A provision represents funds set aside for future expenses or other losses such as reductions in asset value. Types of provisions include bad debt, loan losses, tax payments, pensions, warranties, obsolete inventory, restructuring costs and asset impairment.
What is loan loss provision and how does it work?
Loan loss provisions are used by banks and other lenders to set aside money for unpaid loans and loan payments. They can be used to cover bankruptcies, defaulted loans and loan restructurings that result in receipt of lower payments than originally expected.
When to set aside provisions?
Provisions should be set aside when the company is aware of a probable future expense or loss. GAAP defines probable as likely to occur, an event that has 75% or greater likelihood of occurrence. IFRS interprets probable as “more likely than not,” which would be a probability of greater than 50%.
What is the accounting entry for provision?
A provision is debited as an expense and also credited to the corresponding liability account.
How are provisions treated in accounting
Provisions are recognized as an expense on the income statement, in the same period as any related revenue or when reasonably estimated. The provision increases the related liability or contra asset account on the balance sheet.